Category Archives: Commentary

The US continues to post moderate growth, though pockets of weaknesses remain. Global financial markets started the year trying to read the magic eight ball of the Chinese equity and currency markets – a recipe for emotional distress. Overall, my judgement about the current expansion remains unchanged with slightly above-average growth.

The US economy

· Our Astor Economic Index® (“AEI”) shows growth somewhat above the ten-year average and slightly better than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

· The most important and timely indicators for December 2015 were mixed. On the positive side, payrolls were quite strong and above expectations. The only quibble with last Friday’s report being recent signs of wage growth seem to have stalled. I believe a sustained period of real wage gains will be necessary for a robust consumer sector and hence a strong economy.

· On the bad news side, the weakness in the manufacturing sector as measured by the ISM Purchasing Managers Index continued. Industrial production, as measured by the year-over-year change in the Fed’s industrial production index, turned negative for first time since the recession in last month’s release. I tentatively started calling a manufacturing recession last month and I feel a bit stronger about that now. The non-manufacturing PMI is still fairly strong and though it is off its recent highs, it is still about the average level in the current recovery.

· The Fed finally began to raise rates with its December meeting. 2016’s market volatility, on its own, is unlikely to cause the Fed to reconsider its path unless it gets more extreme. It is said central banks tighten according to plan and ease in reaction to events. The consensus seems to be that the Fed’s plan is to tighten a quarter point at every other meeting or so for a while, as long as the economy continues to hold its present course. Weak inflation prints, however, could give the FOMC pause. With energy prices moving lower again this year it is hard to see early inflation prints being strong. See Tim Duy’s dissection of the December minutes for more.

· If the Fed does stay the course, the next big obsession for Fed watchers will be when they will begin to allow their QE investments to roll off. The Fed currently reinvests coupon and principal payments on its portfolio in similar securities so as to maintain a level portfolio. The first step to reducing the balance sheet will be to cease this reinvestment. (For a dated but still, I think, correct description see my Cleaning Up After The Party Is Over). Expect fevered commentary about the issue this summer if nothing else spices up the dreary lives of central bank observers.

The international environment

· My reading of the global picture has not changed. The fundamental fact of the global economy today is the weakness in China and the attendant disruption in the supply chains built up to feed its growth. I believe we see this result in the broader commodity weakness as well as the manufacturing weakness discussed above.

· There is a great deal written on the Chinese economy, not all of which increases understanding. A few pieces I appreciated:

· Note too that the US is not alone, the UK’s industrial production also recently turned negative year-over-year. Globally, the GDP-weighted manufacturing sector PMI has been declining steadily for the last 18 months, though it is still above the lows seen in this measure in 2012. Note too that those low levels were associated with a stagnation, not a decline, in the level of global industrial production.

Sources: Bloomberg, Markit, IMF, Astor calculations

· In addition to the diffuse reduction in commodity demand, there is an energy specific supply shock. One can imagine this an oily game of chicken among suppliers waiting to see who will take remove supply from the market first.

Conclusions

Overall, I see the US as currently in modest growth and perhaps we should be pleased the Economy has done as well as it has in a challenging external environment.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The Fed sees inflation a bit differently than many in the markets do. In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again. Macroeconomists in general would not describe inflation as a well-understood problem. Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.” Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices. Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive. Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this. And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade. In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation. What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI. But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation. What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation? Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s. A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd. This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation? The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization. But, again, this is only for the current level of inflation. What can we use to forecast tomorrow’s level of inflation? For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation. This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn? The expectation of inflation expectations? Nevertheless, this seems to be the best that economist have for the time being. People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed. The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too. The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke. I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored. Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations. A long period of actual inflation away from the target will likely eventually shift inflation expectations. However, no one knows the parameters of such a function. The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date. The Fed believes that is because of temporary factors which should wash out over time. We shall see. The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target. At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes? Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later. This calculus is all based on keeping inflation expectations well anchored. The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation. To that end, it seems to slow growth slightly. The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense. Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much. My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now. Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level. I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The US economy continues its pace of modest expansion. Though self-sustaining growth continues to be the most likely outcome, a few soft spots – mainly related to weak growth overseas – continue to worry. I expect the economy to adapt well to the beginning of a shallow and gradual rate hike cycle.

Our Astor Economic Index® shows growth somewhat above the ten year average, though it is lower than a month ago. The AEI is a proprietary index which evaluates selected employment and output trends to try and gauge the current pace of US economic growth.

Good news first. The broad economy continues to expand as can be seen in the steady pace of jobs growth. It may be a promising sign for the future that construction jobs continue to grow at a slightly faster rate than they have since the Great Recession. The housing sector has been weak in the recovery and improvement would be welcome.

The weakness in the manufacturing sector continues as demonstrated by a range of indicators. The latest survey from the ISM was below the line demarcating manufacturing expansion/contraction, though this level is consistent with a growing economy, not a broad recession. This is also reflected in the index of industrial production. The manufacturing sub-index has been weak all year, though not nearly as weak as the mining sub-index.

I see this weakness mainly as a consequence of the slower pace of growth in the Chinese economy leading to broad emerging economy weakness which, in turn, is directly reducing prices on commodities produced in the US as well as reducing overseas demand for US produced intermediate goods. As part of the financial markets reaction to this adjustment the dollar has rallied about 20% against a broad currency index over the last 18 months. The IMF estimates that the dollar movement alone has reduced US GDP growth (by reducing net exports) by about 1% in the last few years.

Will this manufacturing recession spread to the rest of the economy? I do not believe recessions can be forecasted at significant horizons, so I will not lay odds. My guess, however, is that it would take significant further deterioration in the global environment for this to happen. And whatever odds you place on them, it is also possible that the headwinds the US is facing in the external environment will begin to dissipate or at least stop deteriorating next year, a slightly optimistic vision.

The continued decent growth in the US in the face of some overseas challenges is one of the reasons why the Federal Reserve will begin raising rates shortly. They seem to be anticipating the attenuation or reversal of growth constraining factors and hope that by starting rate hikes sooner they will not need to raise them as much. Additionally, if we take the Fed at their word, they are worried about labor market slack being close to completely used up.

If I were on the FOMC I would vote against a hike as the Fed’s inflation target does not seem to be close to binding any time soon and because I would be hoping to decrease the numbers of involuntary part timers as well as try to move the labor participation rate back higher, though demography limits potential gains.

Be that as it may, the Fed is still likely to initiate a rate hike, followed by a stately pace of follow-up rate hikes. Given that the Fed has not begun to shrink its balance sheet (maintaining a substantial stimulus) and that fed funds may only be around 1% a year from now, few serious observers are anticipating that this will seriously hurt the economy.

Overall, I am still cautiously optimistic on the US economy, though less so than last month and I will be watching developments in the export sector closely.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. 312151-336

• Early indications are that October was another month of slow but positive growth in the U.S. and abroad. The monthly nonfarm payroll number for October was the strongest of the year, suggesting that weakness in August and September’s numbers was just noise. Emerging markets continue to be a small drag on the U.S. economy, but there are no signs of a crisis at this point. On the monetary policy view, the Fed continues to prepare the markets for tightening, perhaps at the December meeting.
• At 271,000 new jobs, the month-to-month change in nonfarm payrolls released in last Friday’s employment report was the strongest of the year. In addition, the year-over-year change in wages was as strong as it has been since the crisis, up 2.5% year-over-year. We can hope that wage gains hint at more of the economy’s gains accruing to average Americans to build a firmer foundation for a sustainable recovery. It is worth noting that as the expansion ages we can expect monthly employment gains to moderate and to see strength in the labor market represented as additional wage growth.
• On the international scene my view continues to be fairly strong growth in the developed world and faltering growth in the emerging world. Below, I plot the Purchasing Managers’ Indexes for the major international economies. For China (the epicenter of current concern) the PMIs stopped falling in October, though only time will tell if this level will be followed with renewed expansion or further deterioration. The economies most associated with exporting intermediate or raw goods to China (Australia, Taiwan, Hong Kong, Korea) continue to show contraction in the their PMIs. Indeed, these countries are seeing expectations of 2016 growth marked down. At the same time indexes ticked up in the Eurozone, the UK and Japan last month and a GDP-weighted average PMI increased in October.

Source: Bloomberg, Markit, Astor calculations

• The Fed renewed its hold on investors’ attention last week with Chair Janet Yellen announcing the December meeting could mark the first raise in rates since 2006. Many of us are hopeful that whatever the other consequences, the first hike will at least mark the end of our long purgatory of waiting for the first hike. Focus should shift to the pace and ultimate extent of rate hikes. Given the uncertainty about the amount of slack in the labor market and inflation below target, I expect rate hikes to be much more gradual than in the 1999 or 2004 cycles. In addition, the FOMC members (who have consistently been too bearish in their rate forecasts since the crisis) currently see Fed Funds rate topping out at about 3.5%, well below previous cycles. Perhaps the tightening could be as modest as a two-year long move to a 2% Fed Funds rate
• Why is the Fed interested in rising rates? The FOMC seems to believe the labor market is close to full employment and that core inflation should move back to its 2% target in the next two years or so. Given the uncertain lags associated with monetary policy, the FOMC believes it is best to start to act now.
• Overall, I view the information released in the last month as supporting a slightly more optimistic take on U.S. growth.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 311151-324

• The most recent readings on the U.S. economy show a moderating pace of growth. Both points are worth emphasizing: the US is still growing but at a slower rate than a few months ago. We see support of this statement in the recent nonfarm payroll and ISM Manufacturing report releases. Even at the more subdued three-month average of 167,000 new jobs a month, we will still be net adding jobs above the number of new workers. Likewise, an ISM Manufacturing reading of 50.2 is below where we have been but still signals expansion (above 50). I believe the source of the slowdown is likely the sharp rise in the trade-weighted value of the dollar over the last several months and, to a lesser extent, weakness in the world economy.
• I see the weakness in the world economy as stemming mainly from the dislocation of global growth due to a lower level and a changing pattern of economic growth in China. It seems there is excess in the global supply structures that were built up to supply raw materials to facilitate the rapidly expanding Chinese infrastructure growth. Presently, it appears the Chinese government wants to shift growth to be more consumer oriented in addition to adapting to a more modest rate of economic growth.
• The chart below shows the year-over-year change in the volume of world trade as measured by the CPB. We can see world trade has been at somewhat lower levels since the global financial crisis and even bearing that fact in mind, the volume of world trade is at low though not crisis levels.

Source: CBP, NBER, Astor Calculations

• This world trade number is quite thorough, but not as timely as one would like. The chart above is only updated through July. The next chart shows the GDP-weighed purchasing managers indexes of the 20 largest economies for the last few years. This measure looks to have been slowing over the last few months though it does not look like an emergency.

Source: Bloomberg, Markit, Astor calculations.

• The Federal Reserve refrained from tightening in September though they made a special point to say October 28 is a live meeting, that is saying one in which the FOMC may raise rates. We can be sure there will be a deluge of Halloween related headlines before the meeting. Should we be braced for something more serious? As far as the market is concerned, the FOMC may as well play cards this month as almost no one believes they will raise rates. This belief is because the committee said it is waiting for further labor market strength, but we will not get any additional labor market information before the meeting.
• The Fed is also looking for a conviction that inflation will be heading toward its 2% target in the medium term. How is that side of the Fed’s dual mandate going? The chart below shows three different five year ahead inflation forecasts: the blue and green lines are derived from market prices and the red line is from the Philadelphia Fed’s Survey of Professional Forecasters.

Source: Bloomberg, Federal Reserve Bank of Philadelphia

• The market based forecasts show marked deterioration this year while the survey has held steady the last few months, though somewhat lower than last year. Various Fed officials have said they are looking through the market measures of inflation somewhat, thinking they may be artificially depressed due to temporary factors. A policy maker with a strong bias toward hiking might be able to square that desire that with current inflation forecasts, but I think holding off would be more appropriate.
• Overall, this last month’s data has made us a bit more cautious on the economy, though we do see continued expansion in the U.S. as the most likely scenario.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 310151-305

We see a slightly weaker U.S. environment this month than we did last month, though we still see growth as being above the recent average. The most notable change was in the ISM Purchasing manager’s survey which showed a slower expansion than last month. While this shows manufacturers’ orders continue to expand, this gauge is at its lowest reading in about 2 years. Positive employment trends appear to be steady giving a reason for basic optimism about the US economy.

The most interesting development in the world economy in the last month was the spreading recognition that China is in some sort of slowdown. Note it is not at all clear anything became worse last month, but financial market gyrations have brought increased attention. The opaque nature of economic statistics and the unique character of the Chinese economy mean it is difficult to say with any confidence what is the exact rate of growth. However, we can be fairly sure China is currently growing significantly more slowly than a few years ago.

The crash in Chinese stocks should not directly affect U.S. growth prospects nor should a modest decline in the value of the Chinese currency against the U.S. dollar. As we have been highlighting recently, the concern is the weak world growth environment. Specifically, our concern is the weakness of the countries who have been selling commodities to fuel the Chinese infrastructure boom. It was a good growth strategy for many commodity exporting countries for 15 years and adapting to change will be difficult. It is not clear to what extent the primary and secondary effects of such a slowdown would affect U.S. growth.

The drop in the U.S. stock market is also a concern. We see the chances of a sustained downturn in equity prices to be low as long as the underlying growth in the economy remains intact. We do see some signs of increased financial stress though. The increased volatility in the stock market was partially matched by increases in credit spreads for example. Our proprietary Astor Financial Stress Index is showing increased levels of stress, though not nearly as much as a glance at the CBOE Volatility Index (VIX) would indicate.

The big unknown, and possible cause of some of the stock market’s drop, is the possibility of the Fed hiking short term rates at its September meeting. I do not think the FOMC knows what it wants to do yet. You could say the labor market has recovered so one precondition for a rate hike has been met. However, the prospect of inflation returning to its 2% over the next year or so seems to be harder to justify. Fed Chair Yellen has said repeatedly the timing of the first rise is not as important as the number and rate of subsequent increases which raises the possibility of a “one and done” message coming out of the September meeting. Though I think it more likely the hike will be pushed back to December.

In summary, we see continued economic growth in the United States as the most likely scenario though we are slightly less optimistic than we were last month.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. An investment cannot be made directly into an index.

The Astor Financial Stress Index is a propriety measure of financial market “stress.” The Index is an aggregation of various datasets. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future.

The CBOE Volatility Index (“VIX”) is a widely-used measure of market volatility and seeks to represent the implied volatility of the S&P 500 Index over the next 30 days.

• My current view of the economy is for continued, modest expansion in the US. The proprietary index we track as a primary gauge was modestly stronger over the second quarter, though still below the levels of the fourth quarter of 2014. Likewise, the Atlanta Fed’s current estimate

Source: Federal Reserve Bank of Atlanta

• The jobs market continued to improve in June as 223,000 jobs were added. This measure of employment has been in a fairly narrow range for years and seems unlikely to change meaningfully in the near future. Disappointingly, neither earnings nor hours seem to have increased last month.
• Coincident with the improvement in the economy is an move in expected inflation (as measured by various market measures) back toward the Fed’s long term 2% target. The FOMC members have said that inflation expectations being at the target and employment around potential are the two conditions necessary for rates to be normalized. Inflation expectations were weak in the beginning of the year, and while the Fed claimed to be looking through these readings, they have to be satisfied to see inflation expectations normalize.

• The view from the rest of the world is not so rosy. Europe continues to choose to allow 1% of the population take up all the time of the leaders of an entire continent. The situation is quite fluid and there do not seem to be any obviously good choices for anyone. The best news for US investors may be that the damage from five year train wreck is probably going to stay mainly on its own track, given the amount of time investors have had to worry.
• Mainly, but not entirely. At Astor we track an index of financial stress (similar to the Kansas City Fed’s Financial Stress Index but compiled on daily data). This index has spiked over the last week. It started at very low levels, however, and is still below where we get concerned but nevertheless it shows that other stress-sensitive spreads reacted as much to the Acropolis Apocalypse than they did to the crude or stock market sell offs in the fourth quarter of last year. Stress seems to be dissipating in the last two days but we will keep a close eye on this indicator.

Source: Federal reserve Bank of Kansas City, Astor calculations

• For global growth environment, our GDP-weighted measurement of the PMIs shows most of last month’s improvement was undone, though the measure still shows manufacturers’ orders expanding. The weakness is focused in Asia, with the PMIs for China little changed and the Asian economies whose most important trade relationship is China (Taiwan, South Korea, Australia) showing additional weakness. All three of these economies show shrinking manufacturing orders as measured by the Markit PMIs.

Source: Bloomberg, Markit, Astor calculations

• Overall, the US is continuing to grow in a challenging external environment.

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All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.